Rising sovereign risk premia and the profile of fiscal consolidation

Higher sovereign risk premia can have important valuation effects on bank balance sheets. A vulnerable banking sector, already suffering recapitalisation pressures from loan losses, faces additional pressures from declining sovereign bond prices, forcing banks to raise lending costs. This sovereign risk channel constitutes a potentially important transmission from sovereign bond prices to the private sector. For highly indebted countries in the euro area this section shows that the negative output effects of higher sovereign risk premia and expectations of sovereign default can exceed those of fiscal consolidation, implying that the counterfactual of no consolidation could make such countries worse off. This illustrates that the risks to backloading fiscal consolidations, in particular doubts that the necessary consolidation will be implemented at all in the future, could be amplified by the costs of raising expectations of sovereign default, especially if there is no credible long-term consolidation strategy in place.